Volatility Tracker: Implied Correlation as a Reflation Proxy

Volatility Tracker for the week of August 31, 2009

The CBOE Implied Correlation Index spiked to its highest level last week since the beginning of the rally that began this spring. [10] In a healthy, normally functioning market, companies that succeed will see their stock prices rise, while the stocks of failing companies will fall. In a healthy, normally functioning market, the stocks of winners and losers alike won’t rise or fall together in lock step; but the increase in [10] denotes increased expectations of just such a phenomenon. There’s an old adage that, in a crisis, all correlations go to 1. As the implied correlations of S&P 500 stocks push toward crisis levels, momentum- and sentiment-based long positions should be watched carefully. It is intuitive that, as we watch “junk” and quality stocks both rise week after week, expectations of high correlation are just a proxy for the efficacy of reflation efforts. But indiscriminate reflation is no more a sign of a healthy economy than are falling stock prices.

Following up on last week’s discussion of price distributions and kurtosis, I ran a simple strategy test beginning in 2000 that buys the S&P 500 when its one year kurtosis is above a 200-day simple moving average, and moves to cash otherwise. Returns weren’t outstanding, but still beat the market handily, and (more importantly) the strategy was in cash about half the time. Accounting for returns on cash would obviously improve results. I don’t have any broad lesson to extract from this, except perhaps that no expensive analytics software package can remove the need for a basic knowledge of statistics.

I still like a long orientation on oil volatility; another round of straddles may be in order. [16,17]

I’ve elected not to post the individual graphs here this week, and won’t do so in the future unless enough readers object.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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